Mumbai, Dec. 3: Reserve Bank of India (RBI) governor Duvvuri Subbarao today said banks needed to raise the interest rates they paid on deposits while trimming their lending rates and suggested this could be achieved by slashing intermediation costs.

Essentially, the RBI governor wants the banks to bring down their net interest margins (NIMs) — an important measure of a banks operational efficiency. NIM is the difference between cost of funds and the interest earned on funds. Banks have been keen to raise — or at least maintain — their NIMs.

Addressing delegates at Bancon 2010, organised by the Indian Banks Association (IBA) and the Central Bank of India here today on five frontier issues in Indian banking, the RBI governor explained that by bringing down interest rates on advances and raising deposit rates, household savings could be channelled into investment and this could lead to not only double-digit but also inclusive growth in the country.

Subbarao added that although the NIMs of domestic banks had come down to 2.5 per cent from 3 per cent earlier, they were higher than those prevailing in several emerging market economies even after accounting for mandated social sector obligations such as priority sector lending and credit support for the governments anti-poverty initiatives.

The RBI governor, therefore, asked banks to focus on optimising operating costs that included non-interest expenses such as wages and salaries, and transaction costs.

The RBI governor said the time had come to rewrite the archaic laws governing the banking sector. He felt there were too many legislations and this had created an unequal playing field.

Each of the statutes was crafted in a contemporaneous setting reflecting the needs and concerns of the time; and almost all the statutes have had to be amended from time to time to reflect changes in circumstances and context. There is a strong case for reviewing all the various legislations and recasting them for a number of reasons, he told the gathering that consisted of the top bankers in the country.

However, the RBI governor was critical of finance minister Pranab Mukherjees initiative to push through banking reforms by establishing a financial sector legislative reforms commission to drive the process.

Subbarao said the industry needed to debate the changes before the commission was given a clear mandate on the policy directions.

Policy directions should drive the work of the legislative reforms commission and not the other way round, said the RBI governor who has increasingly been at odds with the finance ministry on several issues, including the role of the RBI itself.

Subbarao further averred that when it came to foreign banks, the subsidiary route was preferable while allowing them to start operations in the country.

At present, the central bank allows foreign banks to come in either as a branch or a subsidiary.

There are 34 foreign banks in India who account for a little over 7 per cent of the total assets of commercial banks.

The subsidiary form of presence provides several comforts to regulators. First, managerial decisions in subsidiaries are mainly driven by local economic conditions. Independent directors on the boards of the subsidiaries provide sufficient separation between the bank and its owners, he added.

While various experts have in the past called for consolidation in domestic banking, Subbarao said the central banks view was that the process should be market-driven, based on profitability considerations and brought about through a process of mergers and amalgamations (M&As).

He said the initiative for this ought to come from the boards of the banks which had to make a decision based on a judgement of the synergies involved in the business models and the compatibility of the business cultures.